Picking Winning Stocks

In my previous post, I talked about the stock selection process.  Specifically, finding a company that meets your criteria, estimating intrinsic value, establishing a margin of safety, putting it on a watch list, and waiting for your target buy price.  You are probably thinking most of that is straight forward except for “estimating intrinsic value”.

Intrinsic value is tricky because unlike market price or book value which are readily available, intrinsic value is based on estimates and future projections.  If a dozen people were given a set of financials for a company and asked to calculate intrinsic value, you would have a dozen different figures.  This is why margin of safety is so important.  The idea is to find obvious undervaluation when picking a stock.  If intrinsic value ranges from $8 - $10 and the stock is trading for $5 it doesn’t matter if you are off a little on your intrinsic value estimate.

As a finance guy, I determine intrinsic value by looking at current sales, margins, tax rates, capital spending and working capital requirements.  Once you understand those inputs, you must project future growth and what may happen to all of these inputs in the future.  Basically, you need to be an expert in business valuation.  

What surprised me from my days working in Corporate Finance was the limited number of financial analysts who had any idea how to value a business.  If most finance people can’t figure it out, what’s a normal person to do?  And if you don’t know what a company is worth, how do you know the margin of safety you are getting relative to the current stock price? And if you don’t know the margin of safety, how do you know if you are getting a bargain or overpaying for the stock?

In a bull market, you may not care about any of this.  When markets are climbing and everyone is optimistic, just about everything goes up.  But when markets turn, you don’t want to own a stock that is trading for $100 but is only worth $10.  These are the ones that fall the hardest.  It’s the difference between volatility and the permanent loss of capital. 

When markets fell in 2000, you would have done well in value stocks (undervalued stuff) while the tech heavy NASDAQ fell 80% from its peak.  It took 15 years for the NASDAQ to break even following that decline.  I remember the “experts” saying Cisco was the name you had to own.  Cisco traded at $75 on March 20th, 2000.  Today it trades for $45.  Still down 40% after 20 years.  Believe it or not, this is one of the more favorable outcomes.  Most of the highfliers from 2000 are no longer around.

So, is there a simpler way to find undervalued stocks if I don’t want to make a career out of doing business valuations?  Great investors like Buffett, Klarman, & Einhorn would say there are no simple formulas for picking winning stocks.  However, there is plenty of research showing that mechanical value investing done consistently with a lot of patience can deliver market beating returns.  If this is true, which metric should we use?  Here is a list of the most popular ones:

·         Trailing P/E:         Price/1-year trailing earnings
·         Forward P/E:         Price/1-year future earnings (based on consensus estimates)
·         P/S:                        Price/Sales
·         P/B:                       Price/Book Value
·         P/CF:                     Price/Cash Flow (net earnings + depreciation)
·         FCF/EV:              Free Cash Flow/Enterprise Value

Morgan Stanley put a team of people together to determine which metric delivered the best performance going back to 1997 (22 years).   They looked at 4,000 stocks and tested 81 different metrics.  The best measure was FCF/EV which significantly outperformed the market over the 22-year period.  The metric that performed the worst?  The forward P/E ratio.  Do you know which metric is cited the most on CNBC by bullish guests?  Yep, the forward P/E.  They like this ratio because it is based on future estimated earnings from analysts and they tend to be overly optimistic which makes stocks appear much cheaper than they really are.

For those of you who want to play at home, I will drill down further on FCF/EV:

Free Cash Flow (FCF) is operating cash flow less capital spending.  It is a simple calculation you can lift from the cash flow schedule.  Free Cash Flow is the cash available after all the needs of the business have been satisfied.  This left-over cash can be used for debt reduction, dividends, or share repurchases.  I pay more attention to FCF than any other figure.

Enterprise Value (EV) is market cap + total debt – cash.  You are basically looking at a company and adjusting for the cash and debt on the balance sheet to determine what the underlying business is worth.  Let’s say someone is selling a small local business.  Their asking price is $500K.  When you look at their balance sheet you see they have $200K in cash and $25K in debt, so you need to adjust for this.  The Enterprise Value would be $500K + 25K - $200K = $325K.  The $325K is what you are paying for the underlying business.

The following S&P 500 companies have the highest Free Cash Flow relative to Enterprise Value:   

1.      Delta (DAL)
2.      Cisco (CSCO)
3.      McKesson (MCK)
4.      AmerisourceBergen Corporation (ABC)
5.      Cardinal Health (CAH)
6.      AbbVie Inc. (ABBV)
7.      Altria (MO)
8.      Viacom (VIAB)

Now this is the challenging part about value investing.  Buying cheap works over time but you need to own a group of them, and you need to be patient.  If you do further research on these companies, you will find they all have challenges they are dealing with which is making their stocks cheap.  You are making the bet that their future will not be as bad as what is currently priced into the stock. 

As Warren Buffett says, “you pay a high price for certainty”.  With these companies, you are paying low prices because of uncertainty.    


    

             








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